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Investing in Times of Turbulence : How Options Keep You In the Game

It should surprise no one when I confidently make the statement that someday the great bull market of the past six years will come to an end. The question we all want to know is – when? While I do not have a crystal ball providing that answer, I can clearly see that 2015 is starting out on a bumpy path with sharp intraday price swings creating lots of volatility in portfolios. While the overall S&P 500 has reached new highs, it appears to be doing so with low volume and less “gusto” than has been seen in prior breakouts. Uncertainty in the oil market, as well as unprecedented volatility in currency markets, is “rattling the cages” of many investors as we begin to consider the possibility of a Fed rate hike in the “not too distant” future. All this being said, it is a tough case for stock market bears to argue that stocks are poised for a dramatic fall in 2015 as we do have a continuation of underlying slow strength in the U.S. economic backdrop. Stock market bulls make the case that equity prices will continue to rise throughout 2015 based on three arguments I outline in this blog.

It begins with the idea of investors getting paid by companies to remain invested in their shares. According to the Yale University economist Robert Schiller, December 2010 through December 2014 saw the S&P 500 rise roughly 65%. During this same time, dividends paid to investors rose 74%. Bulls argue that this indicates the market has drawn support from the cash that companies have been generating. Investors are twice rewarded through share appreciation as well as greater dividend payments. It does not work this way in all market scenarios. The S&P rose far faster than dividend payouts in the late 1990’s as the internet bubble inflated. Couple this with the fact that low-interest rates make bonds a rather dismal alternative for those seeking higher returns and it helps explain why investors are currently paying a premium for stocks. We see many pundits calling this market overvalued, yet the cyclically adjusted P/E multiple in December 2014 is roughly the same as that of December 2004. The market continued its bullish trend throughout 2005-2007, adding another three years of solid returns.

The second bullish argument revolves around a very patient Federal Reserve. Investors have been concerned for a while now about how the market will react when the Federal Reserve starts to raise short-term interest rates as the central bank’s efforts to stimulate our economy appear to have been successful from the standpoint of gains in employment and growing GDP figures. With levels of inflation remaining tepid, the Fed can be patient about raising rates allowing equities to continue to move higher.

Perhaps the most compelling argument for continued higher equity prices has to do with a very low present risk of recession. The last six times that the S&P 500 produced negative annual returns – including dividends – was when the U.S. economy was in or close to entering a recession. The most recent example was 2008. Prior recessions include 2000-2002, 1990 and 1981. Our current economic data do not seem to signal imminent recession as low gasoline prices, strong auto sales, continued job growth, and more housing construction should help keep our economic engine rolling along. The difference between interest rates on the 10-year Treasury note and three-month Treasury bills tends to narrow before recessions. The spread is currently wider than it was before recent downturns. Many estimate that a recession will not become likely until the economy is growing so fast for so long that the Fed has to raise interest rates high enough that they begin to choke off growth. We appear to be nowhere near that time now.

All these factors taken together indicate that a continuation of the prevalent bullish trend is likely. Yet we know “past performance is no guarantee of future performance”. What is a jittery investor to do? Learn how to protect a portfolio of bullish trades with options, of course! There are many strategies an option buyer/seller can utilize to protect gains accumulated during this bull market while still allowing continued returns should the markets continue to run. One basic strategy is called a married or protective put. An investor who owns shares of an equity can, for a small fraction of that overall investment, buy an “insurance policy” in the form of a put that allows the shareholder to sell his/her shares at a guaranteed fixed price for a set time frame. If in fact, despite all the previous bullish arguments, the market decides to take a bearish turn, you can hold onto those profits you have worked hard to gain. It is one of many strategies we teach at OptionsAnimal that allow investors to sleep well at night – even during times of market volatility – with the knowledge that all trends can be profitable when utilizing options instruments.